China A-Shares: The Implications for U.S. Investors

by
Mari Tsagareishvili, CFA®
| 19 June 2019

Emerging markets have become an important part of retirement portfolios for many U.S. investors. Recently, global index providers such as MSCI and FTSE announced that they will gradually increase the inclusion of stocks from companies incorporated and traded on mainland China in their global and international indices. Therefore, the Chinese equity market is becoming an even greater part of investing in emerging markets, as well as in global equity markets. For U.S. investors, this means the potential for larger exposure to the Chinese equity market in their retirement portfolios, and increased dependency of international equity portfolio performance on local China shares and China’s economy in general.

China’s economic engine accounts for roughly one-fifth of global output, yet foreign investors own a mere fraction of the mainland markets’ stocks and bonds, due to years of restrictive Chinese government policies. Previously, U.S. money managers could access exposure to Chinese equity markets only by investing in Chinese companies that were listed on the Hong Kong Stock Exchange or overseas exchanges, such as the New York Stock Exchange (NYSE). However, access to China’s domestic markets is gradually expanding, as the Chinese government slowly and decisively eases its grip on the flow of foreign money into domestic markets. Due to improved accessibility, Chinese A-Shares have recently become available for non-Chinese investors. A-Shares are shares of mainland China companies that, until recently, were primarily available for purchase only by mainland Chinese citizens via the Shanghai and Shenzhen stock exchanges.

China’s mainland equity market, with a market capitalization of close to $6 trillion, is the second largest equity market after the U.S. and is already surpassing the equity markets of Japan and the U.K. Now that it is opening to foreigners at a more rapid pace, it is expected to continue to grow. According to many analysts and market pundits, this represents an important opportunity for investors. Due to the nature of the A-Shares market, and the recent escalating trade tensions between the U.S and China, many argue that this inclusion introduces excessive risks to U.S.-based investors in an already volatile asset class.

Source: World Bank

The Nature and Potential Risks of China A-Shares

Compared to the U.S. equity market, which is mostly owned by institutional investors, the mainland Chinese equity market is dominated by retail investors. These investors tend to have shorter holding periods for their investments and are therefore more likely to chase short-term results. In the China A-Shares market, over 80% of the trading volume is contributed by retail investors. The majority of short-term investors has led to excessive trading and contributed to the high volatility on the Shanghai and Shenzhen exchanges, especially during market stress. Frequent trading halts and restrictions on investors have caused uneasiness for overseas equity investors. China A-Shares include shares of companies that are state-owned enterprises, and are therefore controlled by the Chinese government. The government control and influence on these companies’ board of directors have contributed to the concerns of overseas investors, since accounting standards, transparency, and the liquidity of capital markets are called into question. The recent escalating trade tensions also have the potential to put Chinese currency and asset prices under pressure, which could contribute to an abrupt and deep sell-off.

Source: Morningstar

The Introduction of China A-Shares into Global Indices

A-Shares make up the largest portion of all share classes in Chinese equities, equaling over 60% of the total equity market capitalization of China. Global index providers are adding these A-Shares in multiple steps and by small inclusion factors. Currently, MSCI includes 10% of total China A-Shares, with plans to raise this to 15% in August and 20% in November, making the China A-Share market close to 4% of the emerging market index by the end of 2019. MSCI has 31% weight in Chinese companies listed on overseas exchanges. MSCI has also indicated that a full inclusion of China’s mainland market is possible in the future. Full inclusion could entail more than 40% weight to combined China A-Shares and Hong Kong-traded Chinese shares in the emerging market index. This leads to question whether the performance of MSCI’s emerging markets will be dominated by its largest constituent country, China.

Source: MSCI

With the inclusion of large-, mid-, and small-cap companies, FTSE’s approach to adopting China A-Shares is broader and more comprehensive than that of MSCI, which only includes large-cap companies. This inclusion highlights the difference between the index providers, and therefore the difference among the passively managed emerging markets funds that track different index providers. The total international equity and global index of FTSE will also experience increased exposure to Chinese mainland shares.

Source: FTSE

FTSE has not yet announced how it will incorporate China A-Shares in its ESG-indices (e.g., FTSE Global All Cap ex US Choice Index). A-Shares names, which pass the ESG screens, are presently under review.

The Implications for U.S. Investors

The inclusion of A-shares in global and international indices has significant implications for investors considering whether to invest in a fund that tracks the index, or one that attempts to outperform the index. Increased weight of China A-Shares in the index means that passively managed options will automatically incorporate increased exposure to the mainland Chinese equity market. As for active managers who are attempting to outperform the index, the decision to own more China A-Shares in their portfolios will depend on whether those companies meet their investment criteria.

The potential increased opportunity for some active international and emerging markets managers has led to more exposure in this market for actively managed portfolios. In addition, as weight in the index of the China A-shares has increased, many active managers have also limited large country deviation relative to the index, keeping China exposure close to the index weight.Therefore, international and emerging market equity portfolios, whether passively or actively managed, have witnessed an uptick in Chinese mainland equity market exposure. However, for active investment managers, China A-Shares will be incorporated with a more diligent and risk-aware process than with their passive counterparts.

The Chinese A-Share market provides a vast opportunity for equity markets managers, with approximately 3,600 stocks listed on both the Shanghai and Shenzhen exchanges, compared to 2,800 on the NYSE. The Chinese companies traded on the Hong Kong exchange comprise a market heavily geared toward financials and internet-related stocks, while A-Share markets are more diversified, in terms of sector and industries. The China A-Share market is also much less efficient, with less coverage by analysts. This could mean an open opportunity for active investment managers to find good quality companies, and potentially add more alpha, as compared to the index.

Conclusion

With the second largest stock market by market cap, the second largest GDP, and accounting for 22% of global trade, China is easily one of the world’s most important economies. China A-shares are now the second largest market in the world in terms of market capitalization. This, coupled with the increasing inclusion by global index providers, makes China A-Shares too significant to ignore. However, due to the unique nature, emerging market investors should be prudent in their diligence and pay close awareness to the country concentration risk in the index. With trade tensions escalating and possible slowing in China’s economic growth, U.S. investors should mind volatility trends and ensure that their emerging market exposure aligns with the long-term goals of their retirement portfolio.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.